The return on shareholders’ equity ratio shows how much money is returned to the owners as a percentage of the money they have invested or retained in the company. It is one of five calculations used to measure profitability. The others are: net profit margin ratio, gross profit margin ratio, return on common equity, and return on total assets.
Unlike the return on common equity ratio, the return on shareholders’ equity ratio accounts for all shares, common and preferred. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%.
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The higher the percentage, the more money is being returned to investors. This ratio helps business owners and financing professionals determine a company’s financial health.
The return on shareholders’ equity ratio is typically used to track a company’s performance over time or to compare businesses within the same industry.
- 1 More about the return on shareholders’ equity ratio
- 2 More about shareholders’ equity
From the income statement and balance sheet figures below, ABC Co.’s earnings after taxes are $20,000 and its total shareholders’ equity is $100,000. This makes its return on shareholders’ equity ratio:
($20,000 / $100,000) x 100% = 20%
This is a very healthy ratio.
Shareholders’ equity (or business net worth) shows how much the owners of a company have invested in the business—either by investing money in it or by retaining earnings over time.
On the balance sheet, shareholders’ equity is broken down into three categories: common shares, preferred shares and retained earnings. It appears together with a listing of the company’s liabilities and assets.
Analysts look at the relationship between equity, liabilities and assets to determine a company’s financial stability.
The example below shows ABC Co.’s mix of shareholder equity and liabilities. It has $1 of equity for every $2 of debt. This means that the shareholders own one-third of the company’s assets while creditors own the other two-thirds. This balance of ownership is at the high end of a proper balance.
Stockholders Equity (also known as Shareholders Equity) is an account on a company’s balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities. By rearranging the original accounting equation, Assets = Liabilities + Stockholders Equity, it can also be expressed as Stockholders Equity = Assets – Liabilities.
Stockholders Equity provides highly useful information when analyzing financial statements. In events of liquidation, equity holders are last in line behind debt holders to receive any payments. This means that bondholders are paid before equity holders.
Therefore, debt holders are not very interested in the value of equity beyond the general amount of equity to determine overall solvency. Shareholders, however, are concerned with both liabilities and equity accounts because stockholders equity can only be paid after bondholders have been paid.
Components of Stockholders Equity
Stockholders Equity is influenced by several components:
- Share Capital – amounts received by the reporting entity from transactions with its owners are referred to as share capitalShare CapitalShare capital (shareholders’ capital, equity capital, contributed capital, or paid-in capital) is the amount invested by a company’s.
- Retained Earnings – amounts earned through income, referred to as Retained Earnings and Accumulated Other Comprehensive Income (for IFRS only).
- Net Income & Dividends – Net income increases retained earnings while dividend payments reduce retained earnings.
Share Capital (contributed capital) refers to amounts received by the reporting company from transactions with shareholders. Companies can generally issue either common shares or preferred shares. Common shares represent residual ownership in a company and in the event of liquidation or dividend payments, common shares can only receive payments after preferred shareholders have been paid first.
If a company were to issue 10,000 common shares for $50 each, the contributed capital would be equal to $500,000. The journal entry would be:
DR Cash 500,000
CR Common Shares 500,000
In addition to shares being sold for cash as in the previous example, it is also common to see companies selling shares on a subscription basis. In these situations, the buyer usually makes a down payment on purchasing a certain number of shares and agrees to pay the remaining amount at a later date. For example, if XYZ Company sells 10,000 common shares for $10 each on a subscription basis that requires the buyer to pay $3 per share when the contract is signed and the remaining balance 2 months later, the journal entry would appear as follows:
DR Cash 30,000
DR Share Subscriptions Receivable 70,000
CR Common shares subscribed 100,000
The share subscriptions receivable functions similar to the accounts receivable (A/R) account. Once the receivable payment is paid in full, the common shares subscribed account is closed and the shares are issued to the purchaser.
DR Cash 70,000
CR Share Subscriptions Receivable 70,000
DR Common shares subscribed 100,000
CR Common Shares 100,000
A few more terms are important in accounting for share-related transactions. The number of shares authorized is the number of shares that the corporation is allowed to issue according to the company’s articles of incorporation. The number of shares issued refers to the number of shares issued by the corporation and can be owned by either external investors or by the corporation itself.
Finally, the number of shares outstanding refers to shares that are owned only by outside investors, while shares owned by the issuing corporation are called treasury shares.
The relationship can be visualized as follows:
Shares Authorized ≥ Shares Issued ≥ Shares outstanding
Where the difference between the shares issued and the shares outstanding is equal to the number of treasury shares.
2. Retained Earnings
Retained Earnings (RE) are business’ profits that are not distributed as dividends to stockholders (shareholders) but instead are allocated for investment back into the business. Retained Earnings can be used for funding working capitalNet Working CapitalNet Working Capital (NWC) is the difference between a company’s current assets (net of cash) and current liabilities (net of debt) on its balance sheet., fixed asset purchases, or debt servicing, among other things.
To calculate retained earnings, the beginning retained earnings balance is added to the net income or loss and then dividend payouts are subtracted. A summary report called a statement of retained earnings is also maintained, outlining the changes in retained earnings for a specific period.
The Retained Earnings formula is as follows:
Retained Earnings = Beginning Period Retained Earnings + Net Income/Loss – Cash Dividends – Stock Dividends
Learn more in CFI’s Retained Earnings guide.
3. Dividend Payments
Dividend payments by companies to its stockholders (shareholders) are completely discretionary. Companies have no obligation whatsoever to pay out dividends until they have been formally declared by the board. There are four key dates in terms of dividend payments, two of which require specific accounting treatments in terms of journal entries. There are various kinds of dividends that companies may compensate its shareholders, of which cash and stock are the most prevalent.
DateExplanationJournal EntryDeclaration DateOnce the board declares a dividend, the company records an obligation to pay, through a dividend payable accountDR Retained Earnings
CR Dividends Payable
Ex-dividend DateThe date on which a share trades without the right to receive a dividend that has been declared. Prior to the ex-dividend date, an investor would be entitled to dividends.No Journal EntryDate of RecordThe date when the company compiles the list of shareholders to receive dividendsNo Journal EntryPayment DateWhen the cash or other form of dividend is actually paid to the shareholderDR Dividends Payable
Applications in Personal Investing
With various debt and equity instruments in mind, we can apply this knowledge to our own personal investment decisions. Although many investment decisions depend on the level of risk we want to undertake, we cannot neglect all the key components covered above. Bonds are contractual liabilities where annual payments are guaranteed unless the issuer defaults, while dividend payments from owning shares are discretionary and not fixed.
In terms of payment and liquidation order, bondholders are ahead of preferred shareholders, who in turn are ahead of common shareholders. Therefore, from an investor’s perspective, debt is the least risky investment, and for companies, it is the cheapest source of financing because interest payments are deductible for tax purposes and also because debt generally offers a lower return to investors.
However, debt is also the riskiest form of financing for companies because the corporation must uphold the contract with bondholders to make the regular interest payments regardless of economic times.
Applications in Financial Modeling
Calculating stockholders equity is an important step in financial modeling. This is usually one of the last steps in forecasting the balance sheet items. Below is an example screenshot of a financial model where you can see the shareholders equity line completed on the balance sheet.
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Thank you for reading CFI’s guide to Stockholders equity. To keep learning and advancing your career, the following resources will be helpful:
- How to Link the 3 Financial StatementsHow the 3 Financial Statements are LinkedHow are the 3 financial statements linked together? We explain how to link the 3 financial statements together for financial modeling and
- Financial Statement Analysis GuideAnalysis of Financial StatementsHow to perform Analysis of Financial Statements. This guide will teach you to perform financial statement analysis of the income statement,
- Financial Modeling GuideFree Financial Modeling GuideThis financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
- How to be a Great Financial AnalystThe Analyst Trifecta® GuideThe ultimate guide on how to be a world-class financial analyst. Do you want to be a world-class financial analyst? Are you looking to follow industry-leading best practices and stand out from the crowd? Our process, called The Analyst Trifecta® consists of analytics, presentation & soft skills
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